Let's say it's your third calendar year working for a company with no vested employer match; you're classified as HCE. You make a mistake of front-loading 90% of your income in the first two months, exhausting the 19.5k limit, before leaving come March 1 for another opportunity.

A year has passed; you didn't contribute to another 401k plan because you knew 19.5k was already loaded (totally missing out on any employer match). However, the old company has now done the nondiscrimination testing of their 401k plan, and Actual Deferral Percentage (ADP) came out as 2% for NHCEs and 5% for HCEs; meaning, the fix is to make enough refunds to HCEs to reduce the 5% to 4%, to be within the 2% of 2%.

Meanwhile, your own total compensation from the old company as an HCE for those two months is 21.6k, and 19.5k is 90% of that.

What will your refund be?

  • Shouldn't you be refunded most of your contribution, on the order of 80% or more? Otherwise, isn't your outsized contribution going to negatively affect a whole bunch of other HCEs who have contributed way less as a percentage of their overall total compensation, causing the whole plan to fail by a whole percentage point?

For an illustration, maybe there's 100 other HCE employees:

  • 25 contributed 0%,
  • 50 contributed 4%,
  • 25 contributed 8%.

The average ADP for HCE is then (0.00*25 + 4.00*50 + 8.00*25) = 4.00 -- i.e., 4%, meaning, the value is within 2% of the NHCE value, and the 401k non-discrimination test would pass.

Then a single extra HCE employee making an outsized 90% contribution by front-loading prior to leaving on March 1 may bring the whole average up by almost 1%!

Should everyone who contributed just get a 1.14% refund equally, or should just the 90% person get the ~82% refund?

  • (0.00*25 + 4.00*50 + 8.00*25 + 90.00*1)/101 = 4.85
  • (0.00*25 + 4.00*50 + 8.00*25 + 90.00*1 - 1.14*(50+25+1))/101 = 3.99
  • (0.00*25 + 4.00*50 + 8.00*25 + 90.00*1 - 82.00*1)/101 = 4.04
  • (0.00*25 + 4.00*50 + 8.00*25 + 90.00*1 - 82.00*1 - 0.15*(25+1))/101 = 4.00

How is the refund determined? In the situation above, who out of the 76 HCE contributors will receive the refund, and of what amount? Presumably, the best and fairest resolution may be to issue refunds just to the top 26 participants: 82% + 0.15% to the 90% employee, and 0.15% to the 25 employees who contributed 8%, meaning, the contribution limit for the top employees is effectively capped at 7.85% in place of 8% or 90%.

I've tried looking for an answer, but was unsuccessful. This concern is never mentioned around front-loading, either; even though enough HCEs doing front-loading only to leave mid-year might as well significantly contribute to the whole plan failing the nondiscrimination test for no particularly good reason, screwing both the employees who left mid-year after front-loading (especially if they didn't even get a full match, and will have to get a refund, whether an outsized one or not), as well as those who stayed.

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